Understanding Business Valuation And Valuation Metrics

By Author: Mary Rose Somera
Total Articles: 94
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What would a willing buyer pay for a business? What would a willing seller sell the business for?

Business valuation regulations have changed in the last few years to cope up with the rules and regulations brought by the Covid-19 pandemic and the global financial recession and recovery. So if you intend to sell your entire business (or a part of it) to venture capitalists, or you are planning to acquire one, it is vital that you make use of valuation metrics and determine the value of your business (or the one that you plan to buy).

Determining the value of a business once a year or so (whether you intend to sell yours to venture capitalists or acquire one) helps with the following:

Ensuring that you do not sell your company short (once you are ready to sell it)
Retirement planning (you can quickly respond to offers if you know what the value of your business is)
Seeking for venture capital financing (to get a head start at calculating pre-money valuation)
Acquiring a company (valuation helps in determining the business that fits your investing style, gives you a good picture of which acquisition ...
... would be favorable for you, and to make sure that you are not overpaying for it or the shares within it)
Borrowing money for your business
Taking on a new business partner
Developing or updating an estate plan or gift shares of the company
Not all business owners who work day in and out building the value for their business may know the real value of their company. While some look at their balance sheet, others look at their cash flow as the basis of the company’s value. In fact, a business’ true value is based on the combination of these factors, along with the other aspects (such as insurable value, capitalized earnings, future earning, cost of replacement, market data, and the intangible yet significant goodwill value).

The Valuation Metrics
Using the valuation metrics, you can compare diverse companies on a variety of aspects (depending on the one that you choose to use). These metrics are also used to assess the business’ growth over time. A business’ steady growth over time is what prospective buyers look for so a consistent improvement of this figure is truly an advantage. No movement on the metrics (or worse, a dip on them) is an opportunity for business owners to look into the deeper issues so they can take the necessary steps to resolve them.

Let’s take a look at the most common valuation metrics and find out how business owners and investors use them in spotting for any setback on the business that affect profitability, in making business decisions, and in raising funds for their enterprise.

PRICE TO EARNINGS RATIO (PE Ratio, Price Multiple)
PRICE TO BOOK RATIO
PRICE TO SALES RATIO (PSR)
PRICE TO CASH FLOW RATIO
WHAT IT MEASURES
Compares the current price of the stock in a company with what this stock generates on a yearly basis
Compares the current assets in a business to its current market capitalization
Helps in understanding the number of sales each share is typically getting over a yearly period
It factors in ‘non-cash expenses’ like depreciation to the income of a company
HOW TO COMPUTE
It factors in ‘non-cash expenses’ like depreciation to the income of a company
Market share price divided by the book value per share
Divide the share price by the turnover per share (turnover per share is computed as the total turnover divided by the number of available shares)
Divide the current share price by the current operating cash flow per share. To get the second figure, divide the total cash flow earned (This is typically done for a 12-month period) by the number of outstanding shares.
SAMPLE COMPUTATION
Assuming a stock that has a price of $30 and annual earnings of $2 is trading on a historical PE of 15 (30/2). If earnings for the next 12 months are forecast to be $3, then the forward PE is 10 (30/3).
Assuming a business has $120,000 of assets, $20,000 of liabilities and 100,000 shares. The equation would be: (120000-20000) / 100,000 which comes out at 1 in this instance. If the market price of a share for this example company is $1, then the price to book ratio would be 1/1, or 1.
Assuming a company with a turnover of $120,000 a year and with 60,000 shares are being sold at $1 each. To get the turnover per share, divide 120,000 by 60,000 (equivalent to 2). Then divide the share price of $1 by 2. This gives us a price to sales ratio of 0.5.
Divide the current share price by the current operating cash flow per share. To get the second figure, divide the total cash flow earned (This is typically done for a 12-month period) by the number of outstanding shares.
INTERPRETATION
– A high number means you might be getting better value elsewhere.
– A low number can mean an under-priced stock, potentially offering a profitable opportunity.
A less than 1 price to book ratio means that a stock is trading lower than its intrinsic value and may provide a margin of safety to investors
Assuming a company with a turnover of $120,000 a year and with 60,000 shares are being sold at $1 each. To get the turnover per share, divide 120,000 by 60,000 (equivalent to 2). Then divide the share price of $1 by 2. This gives us a price to sales ratio of 0.5.
Divide the current share price by the current operating cash flow per share. To get the second figure, divide the total cash flow earned (This is typically done for a 12-month period) by the number of outstanding shares.
PROS
– Valuable when looking into a company that has consistent earnings (year on year)
-The most used ratio (among all the metrics included in this table)
-Effectively used to evaluate how safe an investment is since it adds in the amount of capital can be immediately generated.
-Simplifies the evaluation if the business is undervalued or not.
-Usually used for businesses that are not profitable or those who are still in the stage of reinvesting earnings, this ratio gives a good idea of how it would be beneficial for the business financially if the capital was not used for growth or sustainability.
-Less vulnerable to manipulation, particularly when compared to the price to book ratio.
-The major benefit of using this metric is that it is not prone to manipulation. Thus, it is easier to identify the money flowing in and out of the business which gives you a better understanding of how the business is performing.
-It is easier to evaluate the performance of the business by looking at the cash flow rather than just by assessing using sales or earnings alone.
CONS
-Doesn’t factor in company outgoings. A price to earnings ratio can still be appealing despite a company’s negative cash flow.
-This type of valuation metric isn’t as useful for evaluating businesses in different niches or industries
-This ratio can vary and often change. This value would be lower if the company gains value. But then it would rise should the company acquire liabilities.
-This ratio doesn’t consider assets that have no physical value like brand awareness, reputation, etc.
Only revenue (and not profitability) is being measured and addressed in this ratio. This results to getting a wrong impression that the stock or company is undervalued by merely using this metric (from an investment standpoint).
-It would be a tedious process when trying to find the operating cash flow of a company if this metric is not published.
-There’s a tendency to have discrepancies in calculations because of the many different types of cash flow.
Business owners should check on these metrics regularly to assess their current position and spot the areas that they need to improve on. In ensuring that your business performs in different areas of profitability and sustainability, you should look at different metrics to value (instead of focusing on just one) as each looks at a business in different but important ways. As you can never be sure which one would appeal to potential investors or acquirers, it’s important that you reconcile these metrics to arrive at a reliable and supportable fair market value. Our team at Credo has qualified valuation experts who can help you delve into ways to reconcile metrics that would generate values that are corroborating with each other.

Investors should be cautious when using these metrics because each has its own pros and cons. Knowing which one is most suitable based on the investor’s investment style is crucial to evaluate how safe an investment is. If you are an investor who is looking to either acquire a company or buy stocks and you are unsure which metric suits you, you can always check on all of the given metrics (or seek the assistance of a valuation expert) before you make any absolute decision.

What You Need to Know When Using Valuation Metrics

While valuation metrics are useful, you have to take note that there are limitations to each (the same as when relying on valuation analysis in general).

Valuation metrics are based on historical data (and sometimes on the forecasts of the analysts). This means that the ratios can either be backward looking or are merely based on estimates.
Valuation metrics should not be the only focus when appraising a business or when making an investment decision. These metrics should be used together with other appraisal methods to get a better idea of the real value of a business.
Valuation is just one of the many factors that affect stock prices over time. There are other economic growth factors that should be considered such as earnings surprises, momentum, and sentiment.
There are conventional ways of evaluating a company (if you intend to invest). Always make sure to do your research about the company and look beyond the numbers that are associated with it.
There are investors who find distinctive opportunity in growing a business (they don’t just rely on the metrics). Take note that this aspect is not factored in when using the valuation metrics (except if potential figures are included when calculating each ratio).
Business valuation is not an exact science. There are lots of things that can go wrong. Prudence, caution, and healthy skepticism are needed in selecting the data to input into a valuation model.
Understand Business Valuation and Valuation Metrics with the Help of Credo Team

Business valuations can be complicated that’s why you need the help of an expert like Credo Team who can guide you in the process. No matter your industry, our team can assist you in assessing the suitable standard and method for evaluating the business in question. We go across industries, look for comparable enterprises around the country and utilize stock or purchase price factors in order to arrive at a fair market value.